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Size of the OTC vs Exchange Traded

derivatives maket
Convergence of Spot and Forward
Bid vs Ask
• Spot and Forward quotes for USD/GBP
exchange rate
Bid Ask
Spot 1.5541 1.5545
1 month forward 1.5538 1.5543
3 month forward 1.5533 1.5538
6 month forward 1.5526 1.5532

•From the perspective of a dealer


•If you wanna look from your perspective then never forget : world is your
enemy
S-K
K -S
Relationship between F & S
• Consider a stock paying 0 dividend worth $60.
One can borrow or lend money for 1 year at
5%. What should the 1 year forward price of
the stock be ?

Ans: 63
Relationship between F & S
• What would you do if Forward is priced at
$67.

Profit - 4
Relationship between F & S
• What would you do if Forward is priced at
$58.

Profit - 5
Options
• Call
• Put
• Exercise Price/ Strike
• Expiry / Maturity
• American
• European
Prices of call option on Google; Stock
Price: bid $871.23, offer 871.37
Prices of call option on Google; Stock
Price: bid $871.23, offer 871.37
• Cost to enter a forward vs options
• Price of call option decreases as the strike
prices increase
• Price of put option increases as the strike
prices inrease
Possible Positions

• Long Call
• Short Call
• Long Put
• Short Put
Payoff - Long
Payoff – Short Call
Payoff – Short Put
Questions
• An investor enters into a short forward
contract to sell Rs100,000 for US dollars at an
exchange rate of Rs60.25 per dollar. How
much does the investor gain or lose if the
exchange rate at the end of the contract is
• A) Rs.60.12
• B) Rs.60.35
Questions
• A trader enters into a short cotton futures
contract when the price is 50 cents per pound.
The contract is for the delivery of 50,000
pounds. How much does the trader gain or
lose if the cotton price at the end of the
contract is
• A) 48.20 cents per pound
• B) 51.30 cents per pound
Questions
• Suppose that a march call option to buy a
share for $50 costs $2.5 and is held until
March. Under what circumstances will the
holder of the options make a profit? Let’s also
draw a diagram illustrating how the profit
from along position in the option depends on
the stock price at the maturity.
Questions
• A trader writes a december put option with a
strike price of $30.The price of the option is
$4. Under what circumstances does the trader
make a gain?
Questions
• A trader writes a december put option with a
strike price of $30.The price of the option is
$4. Under what circumstances does the trader
make a gain?
Questions
• A company knows that it is due to receive a
certain amount of foreign currency in 4
months. What type of option contract is
appropriate for hedging?
Questions
• A US company expects to have to pay 1 million
CAD in 6 months. Explain how the exchange
rate can be hedged using
• A) Forward Contract
• B) Option contract
Questions
• Suppose the USD/Sterling spot and forward
exchange rates as follows:
Spot 1.5580
90 day forward 1.5556
180 day forward 1.5518

What opportunities are open to an arbitrageur in the following situations?

a) 180 day european call option to buy Pound 1 for $1.42 costs 2 cents.
b) 90 day european put option to sell Pound 1 for $1.49 costs cents.
Questions
• The price of gold is currently $1400 per ounce.
The forward price for delivery in 1 year is
$1500 per ounce. An arbitrageur can borrow
money at 4% per annum. What should the
arbitrageur do? As the cost of storing gold is
zero and that gold provides no income.
Questions
• A trader buys a european call and sells a
european put option. The options have the
same underlying asset, strike price, and
maturity. Describe the trader’s position. Under
what circumstances does the price of the call
equals the price of put.
Hedging
• Short Hedge
• Long Hedge
Basis risk
• Hedged and underlying asset are different
• Exact date to buy and sell is not known
• Hedge may be required to close before its
delivery

Basis = S - F
Explanation
• S1 = 2.5 ; F1 = 2.2

• S2 = 2 ; F2 = 1.9

• Short Position
• Cross hedge
• Hedge ratio = Size of the position taken in
futures contract to the size of the exposure
• Minimum Variance Hedge Ratio
h* = ρ (σs/σf)

Required Contract = Size of Position * h/Size of


future
Hedging Equity Portfolio
• Formula
Types of Rates
• TreasuryRates
• LIBOR
• Federal Fund Rate
• Repo Rate
• Risk FreeRate
• Call Rate, MIBOR